Promissory Note: What It Is And How It Works

If you’re wondering about promissory notes, you’ve found the right place. Understanding how a promissory note functions in real estate transactions and other scenarios can prove a helpful way to get a better understanding of the concept. 

Put simply: A promissory note is a form of legal document that outlines and sketches out the parameters, terms, and conditions under which you promise to pay any sums lent under a loan back to a financial provider. 

In taking a closer look at how to write a promissory note and how it operates, it’s also important to consider different types of promissory notes and repayment plans. 

We’ll examine these concepts more in-depth below.

What Is A Promissory Note? 

A promissory note document is a written and signed promise to pay a certain sum of money to a business or individual. 

A legally binding document, it effectively functions as an unconditional promise from a borrower to repay a loan or pay for services in a certain fashion by a specific date as noted in the agreement. Two people are involved in the creation of the document in general: A lender, who will extend any contracted sums, and a borrower (or borrowers) who will owe the money and must repay it in timely fashion.

Typical promissory notes outline and specify basic information about the structure and setup of the loan agreement, including but not limited to amount of money borrowed, repayment terms, and specified interest rate. Descriptions may also contain details on any collateral that’s been put forward to guarantee the loan.

As a legal agreement, you’ll typically see promissory notes used in a variety of financial transactions such as home mortgages, personal or business loans, and loans extended to a party by family and/or friends. The signing of a promissory note is typically undertaken as one of the final steps prior to receipt of funds by a borrower.

For example: Imagine that aspiring homeowners Taylor and Zoe wish to purchase a new residence. Prior to receiving a home mortgage, they must execute a promissory note with their financial lender. The note specifies the amount of money that they’ll borrow for the home loan, whether it’s a 15-year or 30-year mortgage, and the interest rate that they’ll be paying over the lifetime of the mortgage.

Types Of Promissory Notes

You will encounter two types of promissory notes in your financial dealings: secured and unsecured. Differences are whether you must put up collateral with which to obtain the loan.

A secured promissory note requires you to put up collateral, like a car or real estate property, as a way to back and guarantee the loan. Should you default on the debt and/or not make payments in timely fashion under the terms of your agreement, the lender retains legal rights to claim ownership of the collateral. 

On the flip side, an unsecured promissory note does not demand the provision of collateral in order to be executed. In other words, a financial institution that extends one (typically based on your perceived creditworthiness) is effectively extending sums lent on your promise to repay them alone. In the event of nonpayment or late payment, legal action may be required on the lender’s part to obtain compensation or corrective measures.

How Promissory Notes Are Repaid

Several plans are available to those who need to repay a promissory note, with the four primary ways noted below. 

• Lump-sum: Under the terms of a lump-sum agreement, borrowers are obligated to repay the full loan in terms of both principal and interest at the same time to the lender. Your promissory note will specify when your loan is set to come due, and you won’t have to trouble yourself with having to make monthly payments prior to this date.
• Due-on-demand: You may sometimes hear loans of this nature referred to as open-ended loans as well. If you’ve secured one, you’ll be required to repay your loan within a certain predefined period of time after your lender contacts you and formally requests repayment. Loans of this nature are typically utilized to accommodate more short-term requirements for funding.
• Installment: Typically utilized for loans extended for home mortgages, autos, student or personal needs, an installment loan is usually structured around a predefined schedule of payments. Its terms and conditions enable borrowers to repay loans over an extended time horizon. Each payment installment accounts for the inclusion of interest, and you can generally expect your outstanding balance to be broken down into equal monthly payments that must be submitted until the loan is paid off.
  
• Balloon: Under this scenario, you can anticipate making equal payments over the course of a predefined time period that account for both principal and interest, or just interest expenses alone. At the end of the loan term, you’ll then submit a final lump-sum payment that covers any loan balance that remains. Note that certain balloon loan setups require borrowers to make a large one-off payment, which can present budgeting challenges if you’ve not prepared for them in advance.

How To Write A Promissory Note

If you’re issuing a loan, or thinking of obtaining one, you’ll want to know how to write a promissory note and how to interpret one as well. Keep in mind that certain pieces of information must be included in order to make the agreement legally binding. But what specific details that you are required to incorporate into the document will vary based on whether or not the loan is secured or unsecured, and individual state regulations.

A few hints, tips, and points to keep in mind as you think about how to write a promissory note are as follows.

1.  Establish whether the promissory note is secured or unsecured: If it’s secured, you’ll need to specify what collateral is being utilized to secure the loan and under what terms. In the case of an unsecured loan, you won’t have to specify collateral, but may have to take the borrower to court in order to obtain repayment if they default on the conditions of the agreement.

2.  List the borrower and lender: Who will be borrowing the money, and who will be lending any sums that are to be obtained? It’s important to clearly note these items in the agreement, no matter if individuals or legal entities (such as businesses and corporations) are involved.

3.  List the principal amount: The actual balance of the loan and total sum that is being lent by a lender to a borrower. Loan principal speaks to how much money will be extended to meet the party requesting the loan’s financial needs.

4.  Note the interest rate (if applicable): If you plan to charge interest on a loan, it’s important to specify this clearly in the promissory note as well. The law requires you to make it clear how much money that a lender is entitled to for ongoing interest costs, and how much a borrower should expect to pay in interest expenses.

5.  Document repayment terms: Clearly spell out and offer a detailed rundown of the terms and conditions under which the loan must be repaid. As part of this portion of the agreement, you’ll also want to denote the timeframe of the loan, service and support methods, and whom to contact with questions.

6.  Set a maturity (due) date: The date upon which the loan will mature and come due. Spelling it out clearly allows borrowers time to financially plan and budget for expenses.

7.  Agree on payment and prepayment terms: Lenders and borrowers need to agree in the promissory note how payments should be received, in what form, and when they should come due. Likewise, it should be specified what terms and conditions are if prepayment is made on the loan, including if any financial penalties or additional charges will be assessed.

8.  Add default terms: Should a borrower default on a loan, it’s important to have provisions in place that account for legal and financial remedies that lenders can take as well. In other words, if it becomes necessary to seek enforcement, compel repayment, or pursue ownership of collateral, it’s critical that everyone understand the steps, timeframes, and actions involved.

9.  Sign the document: Both parties – lender and borrower – should sign the document as well. Doing so helps to make it legally binding.

10. Notarize the promissory note: Have a notary public witness and notarize the promissory note as well. It provides a legal record of the document’s execution, should attorneys or courts ever need to reference it.

When To Use A Promissory Note

Promissory notes are used in many circumstances when a borrower seeks to obtain a loan from a financial institution or individual. Common instances are noted here.

• Real estate: If you’re looking to obtain a home mortgage, you can expect to execute a mortgage promissory note. In general, lenders will require that your home or investment property serve as collateral. Doing so effectively places a lien on the property and empowers a lender to foreclose on the dwelling in the event of borrower default.
• Personal: A personal promissory note is executed between individuals in the event that one wishes to borrow money from the other. It’s not uncommon to see such agreements take a more informal shape and not include details found in more formal financial contracts, e.g. repayment schedules and structured terms. However, at the same time, it’s important to remember that these are potentially legally binding contracts – and yet, can be more difficult to enforce provided their informal nature. Under any circumstance, it’s important that both parties who are privy to an agreement trust one another and clearly communicate in their construction.
• Commercial: Banks, credit unions and other financial institutions will often issue a commercial promissory note as part of their offerings. You can expect to receive one in conjunction with personal, auto, business or student loans. Most are secured, which serve to put liens on assets put up as collateral (vehicles, properties, etc.) until such time as the loan is finally paid off.
• Investment: If a business is seeking to raise capital, you’ll often find an investment promissory note utilized, which denotes the return on investment that investors can expect to see over time. Note that it’s not uncommon to see stakes in any given company used as collateral here, or to find investors selling promissory notes on to other investors or investment groups at a later date.
• Auto: Anyone angling for car loans can count on executing a car promissory note, which obligates a borrower to make payments in exchange for their receipt of a new or used vehicle. In most cases, borrowers generally make an initial lump-sum down payment then submit equal payments over the lifetime of the car loan.
• Student loan: Understanding how student loan repayment works is important, and that means knowing that promissory notes are commonly utilized when extending undergraduate and graduate school loans. Interestingly, many of these agreements allow interest to be deferred from accruing on any sums lent until such time as you graduate. To avoid any confusion, another common term that you may hear utilized for student promissory notes is master promissory notes, which is generally used in conjunction with federal student loan programs.

Promissory Note FAQs

Several frequently asked questions (FAQs) tend to arise around promissory notes. Answers to the most common can be found here. 

What’s the difference between a promissory note and a loan agreement?

A loan agreement is an extensive and often lengthy and formal contract that spells out all manner of in-depth terms and conditions pertaining to a loan. Though typically less comprehensive in nature, a promissory note generally concentrates on a borrower’s promise to repay principal and interest on any sums lent.

What’s the difference between a promissory note and an IOU?

Think of an IOU as informal way of saying that you owe someone money. It generally carries no legal weight and has no specific terms surround it. A legally binding promissory note is typically enforceable in court and provides more information. 

Does a promissory note need to be notarized?   

Not always, depending on the law and state. However, it does provide added authenticity and legal protections, and may be required in certain states or cases. It all depends on local regulations and individual preferences. Should you have questions concerning the notarization of a promissory note, seek assistance from a qualified legal professional.

Are promissory notes legally binding?  

Yes, in general, and they therefore are a common part of many loan agreements. However, the level of enforceability may depend on numerous factors, which is why it’s recommended that you consult with a qualified legal professional to obtain more information if you have any questions here.

The Bottom Line

A promissory note outlines a borrower’s promise to repay any sums that are extended by a financial lender, and the general terms and conditions under which the loan is offered. You can expect to see such legally binding documents containing basic information about the terms and setup of the loan agreement. That means promissory notes typically speak to the amount of money that will be borrowed, the interest rate at which funds will be lent, general repayment terms, and details concerning any underlying sources of loan collateral.

Myriad financial transactions from home mortgages to personal and business loans incorporate the signing of promissory notes, which are common and typical agreements between borrowers and lenders. Any such debts that you promise to pay within one need to be managed carefully, however. Speaking of: Looking to get a better handle on your finances? Be sure to download the Rocket Money℠ app today to keep better track of any outstanding debts.